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June 17, 2016

On March 9, 2016, Bankruptcy Judge Shelley Chapman of the Southern District of New York issued her decision on the Debtor’s motion to reject certain contracts in Sabine Oil & Gas Corporation’s Chapter 11 case.[i] The decision, which allowed Sabine to reject “gathering agreements”[ii] between it and two “midstream operators,”[iii] Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, under Section 365(a) of the Bankruptcy Code, sent shockwaves through the midstream energy sector and leveled the playing field for bankrupt production companies. Yet, the case leaves undecided the ultimate question – what midstream contracts are protected as real covenants running with the land? That question may be months, or even years, away from any resolution.[iv] In the interim, energy companies are left with Sabine, which implies producers can renegotiate midstream contracts in a slumping energy market, using the threat of bankruptcy and rejection as a powerful bargaining chip to bring midstream operators to the table.

The Decision

By its Motion, Sabine sought to reject four contracts under Section 365, two with Nordheim and two with HPIP. Under all four agreements, Sabine agreed to “dedicate” to the “performance” of the agreement certain leases owned by Sabine and the hydrocarbons from the wells located on the land subject to those leases. For their part, Nordheim and HPIP agreed to construct, operate, and maintain gathering facilities for the respective leases.

When it addressed the Motion, the Court undertook a two part analysis to determine whether Sabine could reject the contracts. First, the Court deferred to Sabine’s business judgment and found “that the Debtors have properly and adequately considered the business and legal risks associated with rejection of the Nordheim Agreements and the HPIP Agreements.”[v] There was little question that rejection would benefit the estate as Sabine indicated that rejection could save it up to $200,000 a month.

The second part of the Court’s analysis was more involved. There the Court was forced to determine whether any of the contracts were real covenants or equitable servitudes that ran with the land. Both Nordheim and HPIP argued that Sabine could not reject the contracts because they were real property interests that cannot be rejected under Section 365. While Judge Chapman acknowledged her inability to decide substantive legal issues under Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), and In re The Great Atlantic & Pacific Tea Co.[vi] without an accompanying adversary proceeding, she dove into an analysis of what constituted a covenant running with the land under Texas law.

After applying Texas’ four-part test for determining whether a covenant runs with the land, the Court rejected HPIP and Nordheim’s contention that their contracts were real property interests. The Court found that the covenants in Nordheim’s and HPIP’s contracts did not satisfy the “touch and concern” prong of Texas’ test for a covenant running with the land. Instead, the interest in the extracted minerals was a personal property interest. The Court also determined that the covenants “do not readily fit into the traditional paradigm for horizontal privity of estate.”[vii] Consequently, the Court made a “preliminary” determination that the contracts between Sabine and the two gathering companies could be rejected.

The Fallout

Despite Judge Chapman’s later statement that “this was not a broad sweeping pronouncement,”[viii] the ruling may significantly impact the energy industry. Moreover, the case and its progeny could shape jurisprudence on the rejection of similar contracts in several energy sector bankruptcy cases while an appeal works its way up the chain. Until Sabine, agreements between producers and midstream companies were generally treated as constants, not subject to renegotiation upon insolvency. That paradigm may now be realigned.

Upstream producers, many of whom are suffering under today’s low energy prices, can now seek concessions from their midstream partners. This places the parties on more equal footing and could actually be a catalyst for negotiated resolution. In fact, courts dealing with the issue may actually prefer the parties resolve the issue through compromise. Sabine has already had an impact in this respect. In In re Magnum Hunter Resources Corp., Bankruptcy Judge Kevin Gross encouraged the parties to resolve a similar dispute before the Court had to weigh in on the motion to reject.[ix] Likewise, in In re Quicksilver Resources Inc., the purchaser of the debtor’s assets was able to reach a compromise with its midstream operator before the Court had to rule on a Section 365 motion.[x] Both cases are examples of how producers have greater power to negotiate terms with midstream companies in the wake of Sabine.

Finally, Sabine is not over. Nordheim’s and HPIP’s adversary case was decided on May 3, 2016.[xi] Once again, in a decision located here, Judge Chapman found “that the covenants at issue in the Nordheim Agreements and the HPIP Agreements do not run with the land either as real covenants or as equitable servitudes.”[xii] On June 1, 2016, Nordheim and HPIP sought Judge Chapman’s consent to appeal that decision. The midstream operators argued that an appeal to the Second Circuit and a subsequent reference to the Texas Supreme Court to decide the state property law issues were appropriate. The Court has not yet ruled on the request, but no one believes that this will be the end of the debate. Upstream producers will continue to pursue rejection of midstream contracts that are overly burdensome and midstream operators will continue to argue that rejection is improper until more concrete guidance is issued by District and Circuit Courts.

[ii]Gathering Agreement means an agreement by which one party agrees to collect oil, gas or other hydrocarbons at the wellhead and transport such oil, gas or other hydrocarbons through a network of pipelines to a central point, often a processing system or an inlet to a larger transportation pipeline.

[iii]Midstream Operator means a company that gathers, transports and processes oil, gas or other hydrocarbons by pipeline, rail, trucks or otherwise.

[iv] On June 1, 2016, Judge Chapman declined to rule on Nordheim’s request for an immediate appeal her decision to the Second Circuit Court of Appeals. While the Court determined that the contracts at issue in the case do not run with the land, in both its preliminary decision and in a later adversary opinion, it left open the question of what type of midstream contract would run with the land such that it constituted a real property interest.

[xi] Following the Court’s decision to grant Sabine’s Motion to Reject, Nordheim and HPIP filed an adversary proceeding in which they sought a declaration that the their respective leases were “covenants running with the land.” The Court, once again, rejected the midstream operators’ argument and issued a final ruling that the leases did not convey a real property interest to the midstream operators.

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